14 February 2014

Fractional reserve bullion banking and gold bank runs: a run or stroll?

The fact that Australia's Prime Minister referred to the global financial crisis as a "shitstorm" will probably just reinforce Americans' Paul Hogan/Steve Irwin view of Australians. Shitstorm is also the title of a book about that Prime Minister's first term and how close Australia came to financial disaster. In that book they cover the bank run that was developing at the time:

"It was a silent run, unnoticed by the media. Across the country, at least tens and possibly hundreds of thousands of depositors were withdrawing their funds. Left unchecked, there would soon be queues in the street with police managing crowd control ... It's a long time since Australia has had a serious run on a financial institution, but it's all about confidence, and you cannot allow an impression to develop generally in the public that there is any risk."

So how did the Australian government stop this bank run? Simples, they just told people they would guarantee bank deposits. End of run. I think it worked because the average Westerner can't conceive of a government becoming bankrupt. If pushed, the government would just print physical cash and send it to bank branches and take on the bank's assets and the average person would feel safe as long as they had that physical cash in their hands.

Now the holders of BB-unallocated are a step ahead of the average person because they hold gold, but the fact that they hold it with a bank tells you they still trust the system. Certainly if there was a fiat bank run, these BB-unallocated holders would request physical gold, but our focus here is if/when and how would a gold run occur, independent of a fiat run.

As I said in yesterday's post, the opacity of the gold market works to suppress run dynamics but paradoxically, that lack of information also means that if a credible rumour can gain hold (ie a narrative develops) then the run will be fast and thus the BB system is more unstable than the fiat banking system in this respect, particularly as even the most naive investors knows you can't print gold.

My best guess as to what could cause these BB-unallocated holders to begin redeeming in large numbers would be multiple reports of failures to deliver. If that coincided with reports of coin shortages it would help. But it has to be multiple reports - this bank, that bank - around the same time. The one off reports/events we have had are not enough to trigger a mass redemption. The fact is people rationalise away such single events. I mean, look at MF Global - people are still trading futures and there has not been any uptick in deliveries vs open interest. I think it needs a clustering of multiple events, and it would help if some of those were picked up by more mainstream news/blogs.

Also, it would be necessary for a large number of people to redeem at the same time. I believe that the gold market is already experiencing a slow gold run, more of a gold walk or stroll. The fact that Perth Mint clients have been increasingly preferring allocated, that non-bank storage services are growing, and other anecdotal stories I've heard (plus a soon to be launched product we are working on with a big bank) show that more and more clients are withdrawing away from BB-style unallocated and becoming risk adverse.

However, the reason I spent so many posts on the structure of the BB system was to show that this slow shift is not a problem for the BBs as they can handle such a move between themselves and central banks - it gives them time to let their gold assets mature into physical.

It is important to note at this point that while BB engages in maturity transformation just like fiat banking, it is mostly short term in nature - BBs don't lend gold out for 30 year mortgages. Even at the height of the miner short selling, a WGC August 2000 report on gold derivatives stated that most of the global mine hedge book was concentrated in the first 4 years and did not extend past 10 years. Today we have hardly any mine hedging, as this chart from Sharelynx.com shows:

Note that the the blue line representing miner hedging is a delta hedged figure where as the OCC figures are notional. The notional miner hedging figure would be much more but I don't have any figures on it. Even so, it would not account for all of the OCC notional figure. The balance would be other short positions (eg Comex hedges, OTC forwards and options, etc) as well as gold lent to industry for inventory funding purposes.

So in a slow burn scenario, BBs can just let their gold leases mature. Indeed, the chart above shows that this is exactly what has been happening, with gold derivatives declining from 10,000t in 2000 to 2,500t today. If miner hedging is basically nil at the moment, what makes up the 2,500t and more importantly, how long is it lent out?

Obviously, part of those OCC figures would reflect Comex and other futures. But note the open interest in futures - there is hardly any volume outside the current contract. This indicates that most speculators are playing short term. As far as the OTC markets are concerned, note that GOFO rates are only quoted up to terms of 1 year. Again an indicator of where most of the volume is, in the short stuff. Finally, the Perth Mint's understanding of the extent of central bank leasing is that the majority, if not all, of it is for terms of one year or less.

The other significant part of the 2,500t figure would be lending to industry for inventory and consignment funding/hedging purposes. The WGC derivatives report estimated this at 1465t as at December 1999. Demand for gold is much higher today so, say, 2000t of gold tied up in refiners/mints/coin dealers (plus jewellery distribution and retailing) is highly realistic.

So my reading of the BB assets is that most of the short selling lending is very short term in nature and thus can mature quite quickly, in months. However, that which is lent to industry, even if terms are less than one year, are more ongoing in nature. While industry could liquidate inventory if lease rates rose (which they would if BBs were desperate for physical), that would not be overly quick, particularly as it would bump up against refinery capacity limitations and in any case, the industry needs a base amount of gold in process to function. So industry inventories can mostly be considered locked out in respect of meeting any BB-unallocated redemptions.

What the OCC chart does not tell us is the size of the unallocated pool and how much of it is backed by physical. In the WGC report, they estimate the total gold lending supply at 5,230t as at December 1999. Whether the OCC notional 10,000t would delta hedge down to 5,230t I don't know, but for our purposes whether the WGC estimate is understated is not as relevant as the estimate that only 520t of that lending came from non-central bank sources - 10%.

With the gold bull market there is no doubt that unallocated balances have increased but if this ratio of central bank to investor lenders then BBs don't have much risk of a run as private investor are only a small part of their borrowings and may be able to be met by repayments from their short term gold loans.

The other interesting data point is the red star in the chart above. That marks the date when BBs started to charge professional investors for holding unallocated. It is not coincidental I think that this happened after the amount of derivatives and mining hedging peaked and started to decline. I also coincides with the beginning of the gold bull market. Why would BBs start to charge a small fee on unallocated, thereby discouraging it? They would if they were facing two trends:
  1. A decline in the demand for borrowing gold, which means they don't need as much unallocated (particularly as they can get what they need from central banks).
  2. More investors starting to buy gold, of which some would be doing by holding unallocated.
The result of these two trends would be increasing amounts of physical gold that the BBs had to hold against their unallocated. If you had OCC derivatives declining by 7,500t but as the same time increasing unallocated balances, then there is no one to lend that unallocated to and the only way to cover it is to hold gold. This increases your costs and thus the need to start recovering some of that by fees. I would note that the fees are in basis points and quite small, so this whole thesis is speculative and possibly overstated. Nevertheless, beginning to charge for unallocated is an interesting data point that should be considered.
Now the picture painted so far is not one which leads to much chance of the BB system being caught out by a slow run. It is possible as well that BBs may be running a much higher amount of reserves against unallocated than many would consider possible. However, I think that this series of post has shown that the BB system is still quite vulnerable. We will discuss that further tomorrow and how central banks may respond to a gold run.


  1. Hi Bron,

    thanks again also for this great piece.

    Not sure if I understood everything, so one question so far:

    Is it correct that the only thing BB would worry about is, what you call a "maturity mismatch liquidity problem"? And if that is the essential "only" problem, would they actually really care, where the price of gold would be going in the meantime as long they can guarantee this?

    And if BBs would run into such a problem, wouldnt the rising price "only" be a problem in terms of increasing the fiat grap (their nominal loss)?

    Greets, AD

  2. If a BB does not have any speculative trading positions then yes, a BB does not have any concerns about what the price is doing and just has a maturity mismatch problem to worry about.

    However, while the BB may be matched (and that is a big if, but let's assume they aren't speculating) its clients are not. So if the price moves against it clients (either up or down depending on whether the client is short or long) then the BB has exposure to those clients if they can't pay up, particularly if the clients are leveraged. In that respect the BB still has some risk to big price moves.

  3. Bron,

    You are a tear here... thank you for the great articles! Cheers!

  4. Bron, Excellent articles.

    Can I please ask if there might be report information, perhaps concerning wholesale premiums or liquidity problems
    available to the professional markets but not the common man, which may account for golds recent price rise ?

    Only last month it appeared banking analysts were unanimous in dismissing the prospect of gold price rises.

    If there is a gold run, the Gold Live Order Board at BullionVault is not so much showing premuims for 400oz bars,
    its simply showing buyers at Zurich for 400oz bars and no sellers. Ever so often a seller seems to come in flashes
    away and then is gone leaving the buyer standing with the same buy order.

    Many thanks for your time and thoughts on this subject.

    "We shall never be able to remove suspicion and fear as potential causes of war until communication is permitted to flow, free and open, across international boundaries."
    Harry S. Truman

  5. Mr Suchecki, thanks for another informed and informative analysis.

    Just a suggestion though. When you create a post, it would not harm if at the first occurrence of an acronym you provide between parentheses the meaning of it. E.g.. BB (bullion bank).

    The matters you address are not always easy, it's a pity that less informed people could be put off just because of jargon.

  6. Great series of articles Bron.

    It's nice to read a straight forward viewpoint on the BB's structural workings from a humble and knowledgeable working source (yourself) instead of the usual wacky, back-patting bravado from some of the hardcore goldbug/doomer sites (fill in the blank).

    I just came from a site where there's a banker death watch of sorts. Some pretty ghoulish maladjusted adolescent stuff out there. Pathetic.

    Keep up the good work.

  7. thanks for the article bron. i saw the link at 24hgold.com

    file this under the jim jones/ego maniac category...


    talk about a self-absorbed shill or what?

  8. I haven't seen anything in the wholesale markets re premiums that would have strongly indicated a certain bottom was in. Hard to say with some analysts whether they are talking their book or just reflect prevailing sentiment.

    Interesting comments we Bullion Vault, although it may just reflect liquidity within that platform, although I would have expected the BV operators to step in and make a market so maybe they are having sourcing issues in Zurich.

  9. Gabriel,

    For some reason google tagged your post as spam. You comment re BB is fair, I had assumed people were following this 10+ post series from the start, but will indicate the abbreviation in every post.

  10. ok....i went to that link above and this came to mind...

    “The Cult Leader"

    They all have or had an over-abundant belief that they were special, that they and they alone had the answers to problems, and that they had to be revered.
    They demanded perfect loyalty from followers, they overvalued themselves and devalued those around them, they were intolerant of criticism, and above all they did not like being questioned or challenged. And yet, in spite of these less than charming traits, they had no trouble attracting those who were willing to overlook these features.

    Here are the typical traits of the pathological cult leader (from Narcissists Among Us)

    He has a grandiose idea of who he is and what he can achieve.
    Is preoccupied with fantasies of unlimited success, power, or brilliance.
    Demands blind unquestioned obedience.
    Requires excessive admiration from followers and outsiders.
    Has a sense of entitlement - expecting to be treated special at all times.
    Is exploitative of others by asking for their money or that of relatives putting others at financial risk.
    Is arrogant and haughty in his behavior or attitude.
    Has an exaggerated sense of power (entitlement) that allows him to bend rules and break laws.
    Is hypersensitive to how he is seen or perceived by others.
    Publicly devalues others as being inferior, incapable, or not worthy.
    Is frequently boastful of accomplishments.
    Needs to be the center of attention and does things to distract others to insure that he or she is being noticed by arriving late, using exotic clothing, overdramatic speech, or by making theatrical entrances.
    Has insisted in always having the best of anything (house, car, jewelry, clothes) even when others are relegated to lesser facilities, amenities, or clothing.
    Doesn’t seem to listen well to needs of others, communication is usually one-way in the form of dictates.
    Haughtiness, grandiosity, and the need to be controlling is part of his personality.
    When criticized he tends to lash out not just with anger but with rage.
    Anyone who criticizes or questions him is called an “enemy.”
    Refers to non-members or non-believers in him as “the enemy.”
    Acts imperious at times, not wishing to know what others think or desire.
    Believes himself to be omnipotent.
    Has “magical” answers or solutions to problems.
    Is superficially charming.
    Habitually puts down others as inferior and only he is superior.
    Has a certain coldness or aloofness about him that makes others worry about who this person really is and or whether they really know him.
    Is deeply offended when there are perceived signs of boredom, being ignored or of being slighted.
    Treats others with contempt and arrogance.
    Is constantly assessing for those who are a threat or those who revere him.
    The word “I” dominates his conversations. He is oblivious to how often he references himself.
    Hates to be embarrassed or fail publicly - when he does he acts out with rage.
    Doesn’t seem to feel guilty for anything he has done wrong nor does he apologize for his actions.
    Believes he possesses the answers and solutions to world problems.
    Believes himself to be a deity or a chosen representative of a deity.
    Rigid, unbending, or insensitive describes how this person thinks.

    Works the least but demands the most.
    Has stated that he is “destined for greatness” or that he will be “martyred.”
    Seems to be highly dependent of tribute and adoration and will often fish for compliments.
    Uses enforcers or sycophants to insure compliance from members or believers.
    Sees self as “unstoppable” perhaps has even said so.
    Conceals background or family which would disclose how plain or ordinary he is.
    Doesn’t think there is anything wrong with himself – in fact sees himself as perfection or “blessed.”

  11. Have there been any substantiated reports of actual failure to deliver a request for physical metal? We have seen a few allocated account businesses shut their doors (ABN, etc) but that was with a lot of advanced notice. Closing a business is different than an existing business not delivering someones ownership. I've not read any cases of the latter, but wondering if I have missed a story?

  12. The mechanics of how the BBs may (or do) operate is very interesting and I applaud the dissemination of your knowledge and perception of it (as you see it).

    I find it enlightening but I view it more as someone describing to me how an internal combustion engine functions while not dealing with what the engine is driving and where it is directed. But you can rightly say, this is not what I'm prepared to discuss (whether from qualification, philosophical mind set, or that it is a completely different subject, etc.).

    And perhaps, this is not the forum to discuss this. But some of the comments (and posts) disparaging the thought (I'm shocked, shocked to find gambling going on here) that there is a grand manipulation in the gold and silver markets incite me to put my views (though they are far from unique) forward. I do it because in my view the criminal fraud perpetrated by this CONSPIRACY strikes at the core of a society and putting your fingers in your ears and singing “lalala, I don't hear you” is just plain stupid.

    And so, I view the BBs, the CBs and those behind them as intrinsic to the discussion of gold and silver and its manipulation. This is about hard money and managing the perception of what money is supposedly. I would argue that it (money) is about the free exchange of my effort through time and space. This presupposes a measuring unit that is agreeable to the contracting parties. I strongly believe that any rational being would favour (after due thought unless he is a Central Banker, economist or other type of idiot) a measuring unit that shows persistence and consistency through whatever contractual period.

    We can discuss (endlessly) whether the value of gold and silver (please note my terminology) is being manipulated versus fiat currencies but the foremost question is why and to what end?

    Debasement of currency has been a given for any society above a certain level of complexity. I speculate that the reasons for this are that the powers that be, through short sightedness, greed, moral weakness and hubris seek to leverage their power over the populace. Time works against them and they over reach, over promise and completely overestimate their “genius”. The majority of the populace will deal with the currency of the realm and not give it a second thought until the currency suddenly turns to shit. Then the powers that be become personally aware of the adage “Beware the thundering herd”. And even then some have the delusion that they can control it. We are not there .......yet. There may be localized breakdowns but until the local populace starts demanding silver and gold coin over other forms of fiat, the CB meme remains in play. The reality is that when trust is lost it takes decades if not centuries to reestablish a base that provides high level (three levels and higher) trust structures of monetary chains that function for the general populace. And I also argue that these higher levels of trust chains are the bedrock of advanced financial systems. These chains of trust are IMPORTANT and it makes me furious when the powers that be intentionally seek to undermine and corrode them.

    This not about gold or silver being so important but about the out and out stupidity and idiocy of trusting these self delusional fools to dictate to us what is of value. There is the “render unto Caesar” reality and if he wants it in fiat, then so be it. Then the question becomes, do you want or need to save your life effort in units that Caesar creates at whim?

    And if it makes me a “goldbug” to believe the integrity of a monetary unit is desirable, then I will wave this flag proudly. Deflation, inflation, speculation and everything else are derivatives of other financial events surrounding a sound currency. At this time in history, Gold and Silver are where it's at though I am willing to consider other viable and trustworthy alternatives. CBs, BBs and their backers manipulate at their peril. I'll just keep stacking.

  13. mikeyj80,

    Looking in detail at some of the "reports" of failure is a post(s) in itself. Many of the reported cases are about people who thought they had allocated but when you look at the contract, actually had unallocated.

    A post on these reports would be a logical follow up to this series of posts.

  14. JohnM,

    I agree with what you say but I think it depends on each country - whether a CB will look to "manage" the gold price depends on how close to collapse they are and whether the population actually has any interest/awareness of gold at all.

    Talking your engine analogy further, yes this series of posts are about how the car works and not the driver or destination. The reason for this is that if you don't understand how it works you can come to a wrong conclusion.

    I think many gold commentators, for example, see the car slowing down and say it is because it is running out of fuel, whereas in reality it is because they don't know there is this brake pedal that the drive is pushing with their foot.